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Reversionary Pensions vs Binding Death Benefit Nominations
Brad Hoffman, Managing Director, Pro-Super, current as of: 17 July 2019.
A Question of Priorities
In recent times, some controversy has arisen as to how deeds are best drafted to accommodate a situation where a SMSF might have both reversionary pensions in place, as well as binding death benefit nominations (BDBNs). In the event of an inconsistency, which one should prevail?
While acknowledging that people can have different opinions, the greatest flexibility and the best outcomes can be achieved where reversionary pensions have a higher priority than a BDBN. There are many reasons for this; however, in order to consider the solutions, it is necessary to outline the potential problems.
At law, a pension can only revert to a dependant of a member who dies. Consider a situation where a superannuation fund member has his or her benefit 100% in a single pension, which they have nominated as being 100% reversionary to their spouse. Now, let’s also assume that they have executed a BDBN to pay 100% of their superannuation benefits to their Legal Personal Representative (Estate).
This is obviously a conflict. What happens if the fund’s deed is silent in relation to which of these inconsistent documents takes precedence?
Until relatively recently, most superannuation fund trust deeds were silent on whether the reversionary pension or the BDBN should take precedence. Once the above dilemma was realised, practitioners had a choice to make and much discussion ensued as to which option was preferable.
At the end of the day, the majority of the SMSF professional community has decided that, on balance, the reversionary pensions should take priority, and we have consequently drafted deeds in that way.
However, a smaller and increasingly vocal minority were of the opposite opinion. Some even went so far as to refer to the majority’s deeds as “defective”.
What is a Reversionary Pension?
A reversionary pension is very specific, but also very valuable. In a nutshell, it is a pension which continues to be seamlessly paid to his or her dependant(s) after the primary pensioner’s death.
There is an alternative which is called a “death benefits pension”. This is one where a dependant has a choice and then elects to receive their death benefit entitlement as a pension, rather than as a lump sum. There are, however, delays and decisions to be made with these kinds of pensions, whereas reversionary pensions simply continue automatically.
The Benefits of Reversionary Pensions Having Priority
Due to the way in which tax laws have evolved, if it is the intention that some or all of a person’s death benefits are to be paid to their surviving dependants (most often, their spouse), it is usually preferable that the benefits are treated as a reversionary pension.
The reasons are multiple:
- A reversionary pension continues seamlessly on to the beneficiary after the member’s death.
- The tax-free status of the SMSF’s income and capital gains in relation to pension assets continues uninterrupted.
- There is no period during which that member’s balance could be said to be unaccounted for, or open to challenge by, other beneficiaries.
- Under the new transfer balance cap (TBC) rules, a reversionary pension does not count towards the recipient’s own TBC for 12 months after the date of the pensioner’s death, whereas a death benefits pension counts immediately.
Additionally, the clarity and flexibility which this order of priority gives to both advisers and their clients is far superior.
Consider an example where a member, on his or her second marriage, wished to leave half of their benefits to their current spouse, and half to his or her children. It would be a simple matter to establish two pensions: one being reversionary, the other being non-reversionary with a binding nomination in favour of the children.
Next, assume that member had divorced and executed a BDBN in favour of his or her children. Later in life they remarried. If they subsequently retired, they could readily start one pension which was reversionary to their new spouse and leave the balance of their benefits to be distributed according to the pre-existing BDBN.
In the event that their relationship soured, they could easily cancel that pension and the reversion would immediately cease. There would be no need for a new BDBN, as it was always in favour of the children.
There are many other examples.
The Problems with BDBNs Having Priority
As indicated above, legally there is a distinction between a “reversionary pension” and a “death benefits pension”. A reversionary pension is deemed to seamlessly transition to the surviving beneficiary.
Conversely, with a death benefits pension there is a gap between death and the commencement of that pension. The moment the primary pensioner dies, their pension ceases. The fund trustee then needs to determine who is entitled to receive the benefit.
If the trustee eventually decides that a particular person entitled to the benefit is also entitled to have that benefit paid as a pension (rather than a lump sum), new pension paperwork is required. All of this obviously takes time, during which:
- The tax exempt status of the deceased’s pension assets disappears, unless and until the beneficiaries decide to pay out a death benefits pension.
- Any flaws in the BDBN are open to scrutiny by the lawyers of other potential beneficiaries, so the intended beneficiary may have their benefits long delayed, denied or significantly reduced due to legal fees.
- No benefits can flow to the nominated beneficiaries until the trustee’s decisions are made.
- There is no 12 month deferral of the transfer balance cap notification for a surviving dependant.
- If strategies had been implemented to segregate taxable and tax-free components, those components become mixed again in accumulation phase when the reversions disappear.
The above only represent part of the problem, with the most serious issue by far relating to whether it is actually possible to enter into valid reversionary pension arrangements if the BDBNs are given priority over reversionary pensions.
The Hidden Risk
Consider the following example:
- A fund has a trust deed which states that BDBNs take priority over reversionary pensions.
- A member has a pension, with a 100% reversion in favour of their spouse.
- The member also has a BDBN which gives 100% of their benefit to their spouse upon their death.
If that member dies, it is arguable that the reversionary pension ceases immediately because there is a BDBN in place. This is despite the fact that the death benefit nomination is in favour of the same person as the reversionary pension – the binding nomination trumps and negates the reversionary pension. So, under such a deed, you would need to be extremely careful to ensure that the wording of your BDBN was exactly right, to ensure a reversionary pension was not invalidated.
It’s not just inflexible and inconvenient, it’s downright risky.
Now, it may be that a future court decision resolves the position as to whether a BDBN can effect or affect a reversionary pension; however, this dilemma would not even exist had the person drafting this deed decided to give reversionary pensions the priority, rather than the BDBNs.
All these considerations – and the practical realities for accountants, advisers and trustees in the real world – should be in mind when deciding how best to tackle this issue.
Often, a choice as to how a particular deed provision is drafted is obvious, and sometimes there are valid arguments in favour of several approaches. In such circumstances, we will usually prefer the one which allows the most flexibility, with the best prospective tax advantages and the most watertight legal claims to a benefit.
While we don’t agree with a decision to prefer BDBNs over reversionary pensions, we would never call it “defective”. It is a considered decision, based on experience.
It is, however, important that the final document is fit-for-purpose and addresses most of the common circumstances which trustees and their advisers are likely to confront.